Who Can Do the Math?

In discussions of the current economic crisis, we hear constant references to “toxic” assets held by banks and other financial institutions. These assets are mortgage-backed securities for which the market has collapsed. As is often the case, this dependence on metaphor is revealing. People resort to talking about “toxic” assets because they don’t really understand what those assets are, or what they are worth.

In principle, the value of any given security, no matter how complex its structure may be, is an empirical question. Yet there exists a wide range of opinion as to the “real” value of the mortgage-backed securities that have clogged our financial system. Some believe that these securities are priced unrealistically low; that we are dealing with the collapse of a securities market, not an underlying collapse in the value of homes or the ability of a large majority of homeowners to make their mortgage payments. On this theory, which appears to be held by the Obama administration, we are suffering principally from a liquidity crisis.

Other observers disagree; they think that many of our largest financial institutions are, in fact, insolvent. This view is based on a pessimistic assessment of the “true” value of mortgage-backed securities. Far-left columnist Paul Krugman is in this camp. This morning on Meet the Press, David Gregory asked Tim Geithner about Krugman’s criticism of the administration’s plan to support the banking industry by facilitating the purchase of “toxic” securities:

GREGORY: Paul Krugman, Nobel laureate, New York Times columnist, been very critical of this plan. He and others have said this is effectively a transfer of wealth from the banks’ balance sheets to the government’s balance sheets. A bailout for the banks, trash for cash. You’ve heard all of these terms.

And in fact, Krugman writes in a column last Sunday that your approach is very similar to your predecessor’s in the Bush administration, Hank Paulson. This is what he writes. I want to have you respond to it. “The common element to the Paulson and Geithner plans is the insistence that the bad assets on banks’ books are really worth much, much more than anyone is currently willing to pay for them. In fact, their true value is so high that if they were properly priced, banks wouldn’t be in trouble. And so the plan is to use taxpayer funds to drive the prices of bad assets up to ‘fair’ levels.”

Mr. Paulson proposed having the government buy the assets directly. Mr. Geithner instead proposes a complicated scheme in which the government lends money to private investors, who then use the money to buy the stuff. The Geithner scheme would offer a one-way bet: if asset values go up, the investors profit, but if they go down, and again, these are all mortgage backed, the investors can walk away from their debt. So this isn’t really about letting markets work. It’s just an indirect, disguised way to subsidize purchases of bad assets.”

Respond, please.

GEITHNER: David, the investor’s money is at risk. They can lose all their money. Now, again, you have to compare these to the alternatives. In the alternative scheme the government, in our view, would be taking on much more risk. The taxpayer will be much more exposed to losses. Life’s about choices. Life’s about alternatives. This is a better way to help get these markets working again.

Geithner, who unfortunately is not very articulate, never did address the key question of the real value of the assets whose purchase the government wants to enable.

Others, including some who are capable of doing the math, believe that the pesssimists like Krugman are wrong. Quantitative analyst Eric Falkenstein is in this camp:

The cost [of Geithner's plan] is actually negative if we think the markets are in a panic, but costs are quite high if we think this is the mid point in a massive financial cataclysm.

Thus, Krugman thinks this is a huge subsidy because he thinks market prices are way too high for CMBS [commercial mortgage-backed securities] and RMBS [residential mortgage-backed securities], though I think this is really because he believes anything that would justify greater government control of economic activity. He has presented absolutely zero data on the prices and corresponding historical loss curves for the various vintage-product types (eg, Alt-A mortgages, 2006, average current price and losses). He doesn’t have the data, he wouldn’t know how to set it up. It’s the kind of detail he is ignorant about but does not think is important. Details matter. Subprime, Alt-A, conforming,vintage, seasoning all matter. AAA 2007 subprime tranches trade at around 25% via the Markit ABX index. Is that really reasonable? What are the losses on the collateral? He just wants to take over the banks asap because asymmetries and imperfect information prove markets are inefficient (heh).

Anyone who is contemptuous of the chronically dishonest Krugman can’t be all bad.

I found 94 subprime mortgage tranches, and some referred to the same underlying mortgage pool. You can find these by going to the Markit ABX index page, looking at the constituents, and see they refer to 20 tranches that vary by seniority for the various grades (eg, CWALT 2007-21CB M Mtge, BSABS 2007-AQ1 A1) . Anyway, the average cumulative 90+ delinquency is about 25%. That’s pretty high historically, but after seasoning 21 months, this means a conservative estimate of total 90+ delinquency is going to be around 50%, and losses on those delinquencies no more than 50% (housing prices did not fall more than 50% in most places, on average). Thats for all of subprime in 2007. The market price for AAA rated assets (better than average) is a mere 25 cents on the dollar, suggesting the average subprime mortgage is priced below that, say 10 cents on the dollar. This is way too low.

I suspect most banks will be unwilling to sell off assets at market prices, because the market prices are so low. In that case the plan ‘fails’, but it would also then cost us nothing, and in the meantime not screw anything up (in contrast to the stress test).

Needless to say, I’m not qualified to resolve this dispute, but I have more confidence in those who rely on data. It does seem, though, that if banks turn out to be unwilling to sell supposedly “toxic” assets at the prices offered, it will be strong evidence for the “liquidity” theory, vs. the “insolvency” theory. This issue, too, came up in Gregory’s interview of Geithner:

GREGORY: But will the banks participate?

And here’s my question, based on our example. Hundred million dollar loan, but the auction price is $70 million. Well, if you’re the bank and you say, “Hey, wait a minute. This is really worth $90 million or $80 million. I’m not going to sell that for $70 million and take that loss on my books.”

Are you going make them sell?

GEITHNER: Banks already hold reserves against that $100 million. So the gap is not between 100 and 70, for example, it’s a narrower gap. Now, banks are going to have an incentive because they want to raise, go raise private capital from the markets. And it’s going to be easier for them to do that if they can show their investors a cleaner balance sheet. And that’ll help improve the incentive for banks to participate.

GREGORY: But you can’t make them sell, can you?

GEITHNER: Well, you can make it compelling and economic for them to sell.

The rubber will meet the road when the auctions contemplated by Geithner’s plan begin.

Another, broader issue is involved in the highly technical debate over the true value of RMBS’s. That is, how serious are the economic conditions we now face? The Obama administration holds two views which, while not necessarily incompatible, are certainly in tension. The first view is pessimistic: we are experiencing the worst economic crisis since the Great Depression. In fact, absent drastic government action we could see another such cataclysm. The crisis is so dire that radical action is required not only in connection with the financial sector, but across the board: everything from education to climate to health care.

On the other hand, the administration takes a relatively optimistic view of the financial crisis itself. Its plan relies on the assumption that there isn’t really a housing crisis and the banks aren’t really insolvent. Instead, if the government helps to prime the market for RMBS’s, the wheels of finance will begin turning once again.

No doubt administration economists would offer explanations of why these views are only in tension, not in conflict. The problem for the administration is that, having publicly and repeatedly announced that it intends to take advantage of current economic turmoil to advance its partisan agenda–”Never let a crisis go to waste!”–it has no credibility. A skeptical public may well conclude that the contrast between its modest approach to the financial crisis and its radical approach to everything else is evidence of cynical opportunism.

UPDATE: My friend Bob Cunningham, who is an expert in this area, adds this cautionary note:

Certainly their approach is more modest than Krugman’s…I think it’s similar to Paulson’s…We just don’t know what they know…I don’t think we can know their real view on the banks’ insolvency….maybe they have ample basis for thinking that it is just liquidity…and that after existing writedowns the long term value of the assets is OK…so PPIP [Public/Private Investment Program] will work fine…

Falkenstein’s analysis is instructive….and plausible…at least for the AAA tranches…but what about the mezzanine tranches?

There is a view that this is just the most politically palatable way to re-capitalize the banks without seeming to do so…and without formally declaring them insolvent….or nationalizing them…

I don’t know…but I wouldn’t dismiss that….OTOH maybe it’s a bet….the liquidity effects of the PPIP might work and everybody will be happy….if it doesn’t…we have much bigger problems….and they’d really rather not discuss that all publicly right now…